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Banking: Europe’s credibility under stress

After omitting an outright sovereign default from its latest banking system stress test, the EBA must set a high capital ratio for banks to pass, or risk losing all credibility.

As Euromoney went to press at the end of March, Portugal appeared to be on the brink of seeking assistance from the EU and IMF to roll over its finances, peripheral sovereign spreads were widening once more, and Ireland was due to present plans to recapitalize its banks that might require senior unguaranteed bondholders to share the burden. And the European Central Bank had managed to convince the markets that it would raise rates in April, as the consensus grows among credit analysts that default rates might have hit a cyclical low and be set to rise before too long.

So it’s a good time to be doing a banking system stress test, as long as it’s a credible one.

Financial markets in Europe have behaved with almost remarkable calm in the light of the continuing and interlinked stresses between sovereign debtors and banks. The contingent liabilities of thinly capitalized and precariously funded banks weigh on the sovereigns; the prospect of losses on holdings of government bonds weigh on the banks.

Sovereign and bank fortunes are intertwined as Deutsche Bank analysts illustrate in their report Looking for credible stress tests by tracing the historical relationship between five-year credit default swap premia for the country’s six biggest banks and five-year Spanish sovereign spreads and yields to Bunds.

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